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Are The ‘Roads Less Traveled’ Even Passable Now?

The good news from today’s data (New Home Sales, which rose to 330k from a revised 267k in May) is that the 24% jump was better-than-expected. The bad news is that the resulting rate is still the second-lowest rate on record. Moreover, we had previously thought that May was 300k and 446k for April; the -33k revision to May and -24k to April compares unfavorably with the +20k upside surprise for June versus the consensus.

The inventory of new homes dipped slightly and continues to plumb new depths. This is good news, in that it will help clear the overhang of unsold existing homes by removing substitutes, but remember there are lots more existing homes than new homes…this is a fairly small positive (albeit, a positive). So the release is not an unmitigated disaster. It is just really bad.

That didn’t stop Bloomberg from proclaiming “Stocks Gain, Dow Erases 2010 Losses on Home-Sales Data.” Hogwash. Bad reporting. Puffery. And so on. But yes, the market did rally.

Stocks with their rally today are at the highest level  since June, and breaking above a line of resistance at 1100 or so on the S&P 500 index (the VIX closed at the lowest level since May, 22.70, but Treasuries rallied slightly, so related markets were mixed.). There is one level left, but if the index can climb above 1123 – less than 10 points away after today’s 1.1% rally – then we are likely to revisit the highs from earlier this year around 1225 in the index. Accordingly, it is a good time to ask: how might my thesis be wrong?

My thesis, to review, is essentially that we have been in a recession continuously since before Lehman’s demise; only the dramatic fiscal stimulus made it appear that we had climbed out of the whole through the simple expedient of bringing demand forward. With C+I+G+(X-M) constituting GDP, if you choose an arbitrarily large “G” then you can make GDP growth go positive; of course, if prudential management of the economy were that simple there would be nothing to do but borrow and spend forever. Obviously, while this equivalence is definition in a single-period model, the crux of the Keynesian stimulus plan is that the public spending will increase confidence and trigger organic growth in C or I or (X-M), so that the G can then be paid back in the next expansion.

Unfortunately, that only works if (a) the adjustment from big G to litle G isn’t abrupt, and (b) consumers and investors don’t adjust to the coming little G by making defensive cuts in C and I rather than being stimulated by it. And yet, through this entire surge in spending, Initial Claims has been steady at a high level, Payrolls continues to be weak, and many other measures of the real economy appear to be still behaving as if there is a recession in place. Both (a) and (b) have been false, and the stimulus appears to have been more or less an accounting adjustment moving growth from 2011 to 2009. Earnings have improved over the last year, partly because the huge hits from the financial sector have dropped out of the calculation, partly because the G is buying stuff from somewhere, and partly because earnings quality has been deteriorating at the margin. Increasing earnings by decreasing credit reserves isn’t organic growth.

My thesis is that this piper will need to be paid because taxpayers (voters) are really miffed at having spent so much to get basically nothing, and will essentially insist on a large downshift in G (a big negative growth rate). This will leave the field to the Fed, who will be under big pressure to pull every trick they know in order to offset the fiscal contraction from government that is coming next year. The Fed has very few tricks left. And whether the problem is even tractable depends in significant part on whether central banks just need to pull the US out of the mud, or the world economy. Europe is also in a state of disarray. I am expecting another year of essentially no real growth, with core inflation bottoming in early Q4 before beginning to rise in 2011 (and potentially rather majestically later in 2011, depending on what the Fed does).

So if that’s my operating thesis, where might I be wrong?

Well, perhaps growth really is recovering. Perhaps the organic growth I was looking for…that we were all looking for…is just late, rather than absent. Maybe the Congress can manage to put into place a convincing deficit-reduction plan for the medium term that doesn’t involve a sharply negative near-term hit. The main reason it currently looks like government taxation and spending policy will be a near-term hit is that the electorate no longer believes any 2-year promise, so this lack of credibility needs to be surmounted in some way. Perhaps the changes at the mid-term elections will be dramatic enough that it will trigger confidence in the People (“yes, we can!”) and some concessions from the White House so that everyone can agree on a plan that gradually reins in government. I am not holding my breath, but it is possible. It hasn’t happened in a while, but elections can produce momentous shifts.

However, for that scenario to play out, consumers and investors need to become confident enough to resume their borrowing ways. Saving, after all, pushes current demand out into the future (Keynesian stimulus is supposed to counteract that effect in a recession). I believe that this is frankly good, and we should all be encouraging our friends and neighbors to, in the slogan I see all over the place, “Chase Home Equity.” It is true, though, that the more they chase home equity now, the lower will be current demand.

Now, it might also happen that the “confidence multiplier” begins to kick in at some point. It is, in fact, a measure of the deep malaise that the country is in that confidence remains mired in a slump despite (some would say, because of) the best efforts of policymakers to make people feel better. But we don’t understand human behavior very well. Perhaps there will be some breakthrough technology on the internet that makes people feel like the future is bright. Perhaps there will be a major medical discovery. Perhaps a really cool person will win American Idol. But at some point, it is possible that some exogenous event defibrillates the American psyche and that organic growth suddenly starts to kick in. If that happens, then the economy might well expand even though the fundamental problems haven’t been solved. This happened in 2003-04 – with everything the Administration and legislature and Fed threw at the economy, they managed to pump up the bubble for another go-round. I really hope this isn’t the end game, because as we should have learned by now the successive bubbles are getting worse (and indeed probably must get worse until the imbalances are corrected). I really don’t want to see the next bust if we don’t finish flushing out this one. Watch private debt; if it turns around and begins to expand again as a fraction of GDP, then this scenario may be playing out.

The other part of my thesis that might be wrong is my inflation forecast. Here, there is lots of room to be wrong. My forecast is predicated on my belief that the Fed is worried about deflation and will try very hard to prevent it, even though it isn’t very close at the moment with core-ex-Housing well above 2%. I also believe that the Congress and Administration will be tightening fiscal variables and that the Fed will decide to inject steroids into the economy to try and counteract that effect. I could be wrong on both counts. Perhaps the Fed is secretly worried about inflation and will be more hawkish than we think. Perhaps Congress and the Administration will delay the fiscal tightening. Or perhaps the Fed will say that fiscal tightening or not, they’re going to focus on inflation and let growth be darned.

I also might be wrong in my belief that money, and not growth, causes inflation, or that private debt causes disinflation but public debt leads to inflation, so that the recent tilt of that ledger makes us much more prone to inflation. Certainly, many people disagree.

So there: lots of ways I can be wrong, and I am sure you can think of others. I believe the counterarguments, if I have been fair about them, are based on a lot of hope and speculation, while the simple math of borrowing to spend, combined with the sudden emergence of rational expectations once the scale of the government’s deficit became clear, is hard to dodge. But I may be wrong, and it wouldn’t be the first time.

What we really need to be cognizant of, though, is what would cause me to change appreciably my asset allocation. What needs to happen to persuade me to get back near my neutral weight in stocks, reduce my cash holdings, or change my weighting in inflation-linked assets? It would have to be something that persuades me the game is back on, at least for one more round – for me, I think that means I need to watch private debt and see defaults decline and the total amount of private credit increase appreciably. Stocks are very expensive for my scenarios, somewhat expensive for a slow-growth scenario, and probably about right for a robust recovery (expensive on visible metrics such as trailing earnings, but at the right part of the cycle that strong growth could redeem the person who buys too rich).


Tomorrow, the data includes the Case-Shiller Home Price Index and Consumer Confidence (Consensus: 51.0 from 52.9). It may seem curious that economic forecasters are looking for an extension of last month’s large decline in confidence. Ordinarily, the modus operandi is to look for a bounce following a big decline. In this case, the big decline was just reversing an apparently-unwarranted surge prior to last month, and consumer confidence moved back into the range. I don’t expect either of these indicators to appreciably change my views or force me to reject my operating hypotheses.

I won’t be writing this commentary tomorrow, because I will be in NYC meeting with some potential consulting clients. I will write again on Wednesday.

Categories: Uncategorized
  1. Mike
    July 27, 2010 at 6:24 am

    Hi, Mike, I’m not nearly as pessimistic as you are, but of course storm clouds seem to be in vogue these days. Europe has actually performed considerably better than the US or Asia since May, and the juggernauts of Northern Europe are in full swing. I am also sceptical of reading too much into consumer confidence numbers, they’re generally a reflection of what happened to stocks during and just prior to the survey period (check the correlation between S&P and Consumer Confidence on bbg, I don’t have it).

    On your other counts I’m more in agreement. Inflation is a monetary phenomena and I do believe we will see a resurgence of the base by the Fed to counteract the coming fiscal ‘prudence’. It exploded in ’08-’09 and has tapered since, but I’m watching those figures for a cue to asset reinflation. If you wonder why the yen’s so strong, take a look at their monetary expansion, which has been non-existent throughout the crisis. If the Fed reignites the baes, and the BoJ joins the party then it will look pretty good for global growth, bad for the dollar and the yen, and your inflation fears will be looming…

    • July 27, 2010 at 7:18 am

      Hi Mike. Thanks for writing! I also am more convinced with the inflation argument than my growth argument. The question for me with growth is how we redistribute the payback…a deep recession now, a shallow recession for a while, or no further recession but a really deep one later. All are plausible. What I can’t convince myself of is that we have completed our penance for 30 years of profligacy!

      The correlation between the changes in consumer confidence and stocks, month-to-month, is fair but not great. The big driver of the overall level is employment. So for forecasting one month’s change, stocks are a decent indicator, but the month-to-month change isn’t very significant to me. But if there are deviations from those points that’s what we should be looking for perhaps: signs of exogenous (positive) shocks to confidence outside of stocks and employment.

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